Inefficient Market / The Daily Reckoning

verfasst von - ELLI -, 25.11.2002, 20:55

-->Inefficient Market

The Daily Reckoning

Paris, France

Monday, 25 November 2002

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*** Deflation? Can't happen, says the Fed.

*** Earnings drop as stocks rise...if this isn't a bear
market rally - it ought to be!

*** Easy credit...a flood of bankruptcies...and Oh, West
Virginia!

--------------------

Oops. I guess we were wrong.

Deflation is No Problem, after all. How do we know? Well,
we read it in the paper.

"Unlikely," said Michael Moskow, president of the Chicago
Fed. The risk of deflation is"extremely small," added
Fed governor Ben Bernanke."Extraordinarily remote,"
agreed the Fed's chairman, Alan Greenspan.

Fed officials seem to be of one mind: deflation is
nothing to worry about. Why then did the Fed cut rates by
an unexpectedly large 50 basis points a couple weeks ago?

Oh that...well...it was just insurance against a"soft
spot" in the economy, explained Bernanke in his speech.

The Fed governors all seemed to be reading the same
script. Just a day or two before, Alan Greenspan had
referred to the economy hitting a"soft spot", too.

Meanwhile, a Fed survey of 35 prominent economists showed
falling expectations for economic growth. The economists
were once looking for 2.6% growth in the 4th quarter;
when the question was last posed, they cut that estimate
in half. For next year, they expect only 2.6% growth.

They could be wrong in either direction, of course, but
now that deflation has been thrice denied by Fed
officials, it seems almost inevitable. The Japanization
of the U.S. economy, worries Stephen Roach, implies
growth rates dangerously close to 'stall speed.'

The financial press has finally picked up on the Japan
example. Fed officials are now routinely asked:"Well,
how come the Japanese have been unable to avoid
deflation? And how will the Fed do better than the
Japanese Central Bank?"

Bernanke didn't wait for the question. The Japanese could
have avoided its bouts with deflation if it had targeted
higher inflation rates, he maintains.

Don't worry about that here. Even if we get down to zero
rates [real rates are already below zero], said the Fed
governor, there are plenty of other things the central
bank can do. Print money, for example."Sufficient
injections of money will always reverse deflation," said
Bernanke.

In the 1930s, he continues, Roosevelt ended deflation by
devaluing the dollar 40% against gold. He might have
added that deflation ended after the worst depression in
America's history had forced 10,000 banks to go bust and
left one out of every three workers jobless.

Is it comforting to know that the Fed can beat inflation
by destroying the dollar and the economy?

Eric?

-----------

Eric Fry in New York...

- Wal-Mart and Home Depot may be having trouble
attracting eager shoppers these days, but the New York
Stock Exchange is having no trouble at all. Investors are
loading up their shopping carts with stocks of all sorts,
especially those pricey, glitzy tech stocks...Goodness,
is there a tech-stock shortage?

- For the week, the tech-laced Nasdaq jumped 4%, while
the Dow chalked up its seventh straight winning week by
gaining 225 points to 8,804.

-"The dissipation of fear and the embrace of risk are
unmistakable characteristics of the market right now,"
Barron's observes."High-grade and junk-level corporate
bonds have both been surging in value versus Treasuries."
Then again, almost everything is surging in value versus
Treasuries. The same economic-recovery delusion that is
enticing buyers into the stock market is also spooking
panicked sellers out of the bond market. Government bonds
tumbled lower all week, as the yield on the benchmark 10-
Treasury note jumped from 4.03% to 4.18%.

- But even though both the stock and bond markets"see" a
recovery coming, hard evidence of said recovery is scant.
Earnings estimates, for example, are falling even faster
than share prices are rising."Expected earnings growth
of Standard & Poor's 500 tech companies for the fourth
quarter have been nearly halved, to 17% from 32% just
since October 1," Barron's reports."Based on next year's
expected earnings, the tech contingent is due to produce
about 5% of total earnings generated by all S&P 500
companies, yet the sector now accounts for 15% of the
index's value." Given the uninspiring earnings outlook for
tech stocks, Barron's concludes that investors are
"looking through the wrong end of the telescope when
eyeing a fundamental recovery in the group."

- Last week's stock-market gains mean that the S&P 500
has jumped more than 20% since October 9th. The jubilant
bulls proclaim that it's a new bull market, while the
bears gripe that it's just another classic - albeit
spectacular - bear-market rally.

- As the bearish Comstock Partners points out,"The S&P
500 is now up 22% from the bottom compared to a similar
22% for the spring rally of 2001 and 24% for the rally
from late 2001 into early 2002." Both of the earlier
rallies withered up and died as the bear market continued
to grind lower.

-"Is the current rally in the stock market any different
from the two that preceded it?" wonders Morgan Stanley's
Stephen Roach."Or is it just another bear trap - a rally
that fails in the face of unrelenting dip-prone
tendencies of America's post-bubble business cycle?"

- We favor the latter point of view...And, if this isn't
a bear-market rally, it OUGHT to be. Stocks are still
expensive and they are still as popular as ever. In other
words, there's more than enough irrational exuberance to
go around.

- Consider the frothy SOX Semiconductor Index."Despite
its recent 38% pop, the SOX is 75% below its top of March,
2000," the Financial Post reports."But in absolute
fundamental terms, the semiconductor sector is far from
cheap. The SOX sports a forward price/earnings multiple
of 535 and there is no trailing P/E because the average
company in the group has been unprofitable over the past
year." That's 535 ESTIMATED earnings! Are these the
valuations that typically launch a new bull market?

- The stubbornly high price for a seat on the New York
Stock Exchange is another straw in the wind suggesting
that stocks haven't yet hit bear market bedrock."The
cost of membership on the New York Stock Exchange,
measured by the price of a seat on the Big Board, has
failed to collapse in the manner typical of every
previous bear market," writes Barron's Michael Santoli.

-"The last sale of a seat took place at a price of $2.5
million earlier this year. That isn't even 6% below the
peak price of $2.65 million, reached in 1999, despite the
fact that the Dow has fallen 25% and the broader S&P 500
is down nearly 40%.

-"John Roque, strategist at Arnhold and S. Bleichroeder,
points out that in the 1929-32 collapse, seat prices were
flattened, to the tune of 97%. The comparable decline in
1968-69 was 93%, and the brief period of distress
following the crash of 1987 pulled seat prices lower by
38%...It isn't clear what should be inferred from the way
seat prices have stayed firm this time."

- Maybe so, but it seems pretty clear to us what should
NOT be inferred:"The bottom is in."

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Back in Paris...

*** Stocks seem to be going up. But should you buy them?
If you enjoy gambling, sure...why not. Maybe the rally
will continue long enough to make a buck.

But here at the Daily Reckoning, we take a different view
towards investing. We buy low so that we might sell high
later. Few stocks are low now, so there aren't many of
them that we would buy.

We may miss a great opportunity to make money - just as
we did in the great bubble of '98 to '99. But at least
we're able to enjoy the show without worrying about how
it turns out.

*** There is a severe shortage of priests in rural
France. Every now and then, none can be found for our
little church in the country. So, we make do with a
prayer service conducted by gray-haired ladies.

"As you do unto the least of them, so do you unto me,"
Jesus had said in Sunday's gospel lesson.

"Be nice to each other," was the spin applied by one of
the gray heads, limping through a sermonette on the
subject.

***"Why did you have to be so critical of West
Virginia," asked a very gray head, rhetorically, at
dinner."It just wasn't very nice."

Even in his own home, your editor finds no shelter. Over
vegetable soup, his mother joined in defense of the
Mountain State.

But he was ready for her:"When you go into a
restaurant," he replied,"do you do the chef any service
by not noticing that his soup tastes like dishwater?"

"If Jules goofs off and doesn't do his homework," he
continued, mounting a horse so high he almost needed a
stepladder,"does it help him when you don't say
anything?"

"If an Enron lies about its earnings...if strategists
make a self-serving call in order to get more IPO
business...or if Alan Greenspan comes up with some lame
justification for driving consumers further into
debt...what possible good could it do to sit silent, like
a groundhog watching a bank robbery?"

"You mean, you think you're providing constructive
criticism," came the hopeful response.

"Well...at least we're providing the criticism... After
all, the Daily Reckoning is free. If people want the
constructive part, they can pay for it."

*** Out in the country, we raise our own turkeys. We
don't know why, but they seemed unusually suspicious and
nervous this past weekend...


-----------------------

The Daily Reckoning PRESENTS: Credit derivatives may win
praise from U.S. banks and Alan Greenspan, but they
encourage analytical methods that contribute to the
reckless expansion of credit and financial volatility,
says Edward Chancellor.


INEFFICIENT MARKET
by Edward Chancellor

This has been a year of record corporate defaults. Yet
thanks to the advent of credit derivatives, U.S. banks
have managed largely to avoid the debacle. Some people
argue that credit derivatives have produced a better
distribution of risk throughout the financial system,
thus increasing the growth potential of the global
economy. Alan Greenspan has even claimed that credit
derivatives are improving the measurement of risks.

On closer examination, however, we find that these
derivatives contributed greatly to the reckless expansion
of credit in the late 1990s. Far from improving risk
measurement, they have encouraged the adoption of
technical credit analysis methods, which are contributing
to unprecedented financial volatility.

According to the British Bankers' Association, the
notional market value of credit derivatives has grown
from $180 billion to over $2,000 billion over the last
five years. Banks (mostly of U.S. origin), securities,
houses and hedge funds have been large buyers of credit
default swaps. Insurance companies and re-insurers
(mostly European) have been net sellers. The banks have
done very well from this. According to Avinash Persaud,
head of research at State Street Bank, despite this
year's corporate defaults of a face value close to $200
billion, the loan losses of U.S. commercial banks are
running at around 10% of equity (compared with nearly 35%
in the early 1990s).

What is good for the banks is also good for the economy,
argues Charles Gave of Gavekal, a research boutique. In
the past, at the end of every economic cycle, the banks
would find themselves with bad loans, which caused their
balance sheets to shrink. The multiplier effect would
lead to the rapid contraction of credit. Under such
circumstances, even sound companies were denied access to
finance. Businesses were, therefore, forced to cut
spending and lay off workers. Gave suggests that all this
belongs to the past. With credit derivatives and the
securitization of debt, banks no longer exacerbate the
economic cycle. However, he admits that his rosy scenario
only holds as long as the 'shock absorbers' in the
financial system continue to operate.

There are several reasons why insurance companies are
unlikely to continue playing the shock-absorbing role.
First, they have been paid too little for the risk they
ended up carrying. As the head of a large European re-
insurer said recently, the industry has provided"naïve
capital" for the banks. Banks were never perfect at
assessing credit risk, but at least their loan officers
realized their jobs were at risk if the loans didn't pay
off.

Once credit insurance appeared, the banks lost interest
in estimating the quality of a loan over its whole life.
All they had to do was originate, sell it on and collect
on the insurance if it blew up. Without an incentive to
prudence, it was inevitable that loan quality would
deteriorate. Banks began playing a greater-fool game of
credit creation.

Another reason why insurers will be reluctant to provide
credit insurance is that they no longer have the
resources to do so. Insurers got into this business when
their balance sheets were bolstered by the soaring equity
market. At the time, many insurers increased the
percentage of equities in their portfolios from the
traditional 10% to around 50%. Thus, their increasingly
important role in the credit process was linked to the
level of the stock market.

As students of Japanese banking will know, this process
makes for both wonderful booms and terrible busts. During
the bear market, the insurers have seen their capital
adequacy ratios decline and have become forced sellers of
equities. Many are now getting out of the credit
insurance business. For instance, Scor, the troubled
French insurer, is set to wind down its $2.7 billion of
credit derivatives exposure over the next couple of
years. Many others will follow.

In the past, banks have been responsible for their share
of folly. As suppliers of credit, however, they had
certain advantages. They knew their customers well and
loans came with a long-term banking relationship.
Furthermore, a multiplicity of banks produced a variety
of opinions.

It is this variety of opinion, according to Persaud,
which is essential for the efficient operation of
markets. With credit derivatives, the assessment of
default risk has been taken away from the banks and
placed into the hands of the insurance companies. Having
no relationship with the debtors, the insurers have
adopted uniform methods of credit risk analysis. Risk is
now measured using technical methods, derived from the
bond and equity markets. This creates the potential for a
feedback loop.

During the bull market, a company's rising market
capitalization was sufficient justification for lenders
to supply it with credit. On these grounds, telecom
companies attracted over $1 trillion of loans between
1998 and the end of last year. The same process works in
reverse: falling equity prices lead to the presumption of
declining creditworthiness and an increase in funding
costs.

Thus a company that is out of favor in the stock market
may find that the insurance company is hedging its own
credit default risk by shorting the firm's bonds or even
its shares. Such activities could send a company into a
death spiral.

The potential for credit derivatives to reduce economic
cyclicality is wonderful. Perhaps their recent troubles
are mere teething problems. However, if they are to play
an important part in the future, credit derivatives need
to be properly priced. The suppliers of credit default
insurance will also need to apply a variety of measures
of credit risk and adopt a more long-term view than they
do at the moment.

They will need to be better capitalized. And above all,
they will need to improve their position relative to the
bankers who originate the loans. Unless the balance of
power changes, you can bet your last dollar who will end
up with the wooden nickel.


Regards,

Edward Chancellor,
for The Daily Reckoning

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• Inefficient Market / The Daily Reckoning - - ELLI -, 25.11.2002, 20:55